Following the result of Brexit referendum in June the Bank of England did not hesitate to implement further steps in monetary easing (further in the meaning of additional to already loose conditions after the great financial crisis). The pound, already nose-dipping to multiyear lows, fell further, stemming inflation in prices denominated in pounds.
The spiking inflation got Britain into an interesting situation. While the rest of the world is struggling with zero lower bounds of nominal rates in order to lower the real rate, the British economy has the inflation card, which (given the constant nominal policy rates) can lower real rates and support business investment. However, even with lower real rates, incentives to invest in an economy potentially losing its passport to the world currently biggest free trading bloc are deteriorating. I believe the main driver of business investment will be the conditions of access to the single market and/or the availability of labour, not the rate of interest in the upcoming years.
On the other side though, low real rates and spiking inflation could harm consumption. First of all, as the referendum result ‘came out of the blue’ with financial markets not pricing it, higher inflation erodes real savings, resulting in a higher propensity to save in the long run to make up for the loss in retirement savings for instance. Secondly, higher inflation adversely affects real income. During the recent weeks several other journals, blogs, and articles argued that increasing price levels would hurt real income, hence depressing the engine of growth: consumption.
Even though, it is difficult to argue against the conclusion that higher inflation has a gross negative effect on real income, since the terms of Brexit are still unknown, I think it is a bit premature to make a call on future real income trends. Labour demand depending on business investments, and supply influenced by immigration are just as crucial in determining real wages as inflation rates. Consequently, we are dealing with (gross) negative influence on consumption, and positive on business investment, but the big question mark is still there regarding the eventual terms and conditions of Brexit.
Given that consumption accounts for 60 percent of GDP in Britain (making it one of the least open economies among G7) one should keep a keen eye on real rates and currency movements. Since British people voted for isolation future economic planning should primarily focus on keeping domestic purchasing power high. In today’s business environment, where nominal yields are scarce, a small increase in policy rates could suffice to support the pound, without making credit terms significantly worse. Dealing with such circumstances and uncertainty it is not straightforward whether easing or tightening monetary conditions would benefit the economy on the long run.